Decentralisation in DeFi is an illusion, says BIS

The Bank for International Settlements (BIS) has called decentralisation an “illusion” before adding that DeFi could undermine financial stability if it gained traction and that more safeguards are needed.

BIS report explained decentralised finance (DeFi) aims to provide financial services without intermediaries, using automated protocols on blockchains and stablecoins to facilitate fund transfers.

It further claimed there is a ‘decentralisation illusion’ in DeFi due to the inevitable necessity for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power.

“But full decentralisation in DeFi is illusory,” the Swiss-based global forum for central banks said.

“A key tenet of economic analysis is that enterprises are unable to devise contracts that cover all possible eventualities, eg in terms of interactions with staff or suppliers.”

BIS noted that centralisation allows firms to deal with this ‘contract incompleteness’.

In DeFi, the equivalent concept is ‘algorithm incompleteness’, whereby it is impossible to write code spelling out what actions to take in all contingencies.

Severe vulnerabilities

DeFi’s inherent governance structures are the natural entry points for public policy but its vulnerabilities are severe because of high leverage, liquidity mismatches, built-in interconnectedness and the lack of shock-absorbing capacity.

According to the report, the so-called DeFi platforms allow users to lend, borrow and save, usually in cryptoassets and stablecoins, while bypassing traditional, centralised gatekeepers of finance such as banks.

Therefore, DeFi has the potential to complement traditional financial activities, but it currently has few real-economy uses and, for the most part, supports speculation and arbitrage across multiple cryptoassets.

The limited application of anti-money laundering rules and customer checks, along with transaction anonymity, according to BIS quarterly review, exposes DeFi to illegal activities and market manipulation.